Apple has a history of perfecting a playbook and then reapplying it to new parts of its business. Similar to the iPhone upgrade program, we believe, over time, Apple’s delightful hardware trade-in experience for Mac, iPad, and Watch will evolve into hardware subscription offerings for these devices. Eventually, we envision the company merging its services offerings, alongside hardware subscriptions, to create a 360° bundle. Think of this as paying a monthly fee to Apple for most of your tech needs.
Both hardware subscriptions and the subsequent 360° bundle align with two macro trends: an ongoing digital transformation and changing consumer buying preferences. Additionally, Apple is the only company that can make this work, given their service and maintenance logistics, along with seamless hardware and software integration.
Hardware-as-a-service is justification for multiple expansion
Today, about 55% of the company’s revenue can be purchased as a subscription. By adding Mac, iPad, and Watch subscriptions, that number will approach 85%. This dynamic will increase Apple’s revenue and earnings visibility which should, in turn, expand their earnings multiple. Our $200 price objective is based on 35x our 2022 EPS estimate of $5.70. As a point of reference, this would be a slight premium to Facebook and Google and a discount to Amazon and Netflix.
The ongoing digital transformation
It’s clear our dependency on tech has accelerated because of the pandemic. What’s less clear is how much of that acceleration is sustainable long-term. Our view is that most of it is. Take, for example, work, in which we estimate the percentage of US knowledge workers working from home will settle at a level 3x greater than before the pandemic. In terms of learn-from-home, while we believe all students will eventually go back to classes in person, we expect greater tech outfitting by educators and parents to facilitate learn-from-home on short notice. With these shifts come a greater emphasis on the reliability and utility of the hardware, software, and services we depend on.
Two Apple data points highlight the recent surge in the digital transformation. First, Mac revenue grew at 29% y/y in the Sep-20, up from 22% in the Jun-20 quarter. These compare to the nine quarters before the pandemic, in which growth was flat on average. The September Mac results were particularly impressive, given in the month of June, the company announced new Macs would be coming in the December quarter. Similar data points exist for the iPad business, which reported revenue growth of 46% and 31% in the same two quarters, compared to on average 4% growth in the nine quarters preceding the pandemic. Going forward, we believe Mac and iPad growth rates will stabilize around 10% over the next few years, representing a step up from flattish growth pre-pandemic.
Aligning with consumer buying preferences
We see two factors contributing to the macrotrend of consumers preferring subscriptions over buying products outright. First, the fast pace of tech innovation leads consumers to want to own the latest and greatest. Subscriptions are an answer to this dynamic, as they offer greater flexibility to upgrade more quickly because consumers don’t absorb the full purchase price upfront.
Next, consumers, particularly millennials and the front end of Gen Z, tend to have a rent vs. buy mentality. A 2019 survey by First Insight found that 31% of millennials use subscription services, compared to 21% of Gen Xers, and 8% of Baby Boomers. The trend of renting over buying impacts all levels of consumption, from low-priced items like music and video streaming, all the way up to high-priced items like home and car ownership. A recent output of this phenomenon is Affirm’s success. Affirm, which is expected to go public soon, is a point-of-sale loan provider for e-commerce companies that allow consumers to buy essentially anything on a subscription basis.
One step between buying and renting is purchasing a product on an installment plan. Today, Apple Card holders have an option to buy hardware with a 12-24 month interest free payment option. This is a compelling offer to defer the devices upfront cost, and the hardware subscription plan offers greater value to the consumer. Using an iPhone 12 as a case study comparing purchasing a phone with Apple Card installments vs. the iPhone Upgrade Program reveals two advantages of the Upgrade Program. The biggest benefit is that the consumer gets a new phone every year, and Apple Care (about $6 per month) is included in the monthly price. In the end, the Upgrade Program option is $34 per month vs. $40 per month using Apple Card installments. Apple doesn’t disclose how many iPhone’s are currently on the iPhone upgrade program. Our observation is the program is slowly gaining momentum.
Apple’s service and maintenance logistics
From a service and maintenance perspective, Apple is uniquely positioned to expand its hardware subscriptions. While offering a hardware subscription may sound simple, the foundations take years to develop. For starters, because a hardware subscription service involves more frequent exchanges between buyer and seller, the first building block is a seamless return mechanism. Apple has been improving this process over the past seven years through its trade-in programs. The company works with third parties, including Brightstar in the US, who refurbish and sell the devices, oftentimes in different markets, which is one of the reasons why Apple’s active device base is growing faster than its annual sales.
In terms of perfecting a playbook, in 2013 Apple launched its iPhone trade-in program. Two years later, the company introduced the iPhone upgrade program, allowing consumers to finance their iPhone through monthly payments and upgrade their phone every year. Apple has since added trade-in options for Mac, iPad, and Watch. We expect the company to replicate the iPhone playbook and add upgrade subscription programs for these devices.
Why Google and Samsung will have difficulty doing the same thing
Google and Samsung both have similar product lines, offering trade-in programs, along with phones that can be purchased through upgrade programs. So what separates Apple’s hardware subscription potential from that of Google and Samsung? With respect to Google, its devices decline in value at a faster rate compared to Apple devices. This diminishes the financial strength of the hardware subscription flywheel. For example, Google offers up to a $229 trade-in value for the Pixel 4, released in 2019 with a starting price of $799, implying a 28% maximum trade-in value. In comparison, Apple offers up to a $350 trade-in value for the iPhone 11, released in 2019 with a starting price of $699, implying a 50% maximum trade-in value.
In regards to Samsung, while we found its trade-in offers are in line with Apple’s, the product line lacks integration between its hardware and software. Apple’s tightly integrated ecosystem provides a better user experience and helps keep consumers loyal to its products. This also helps power the hardware subscription flywheel.
For hardware subscriptions and ultimately a 360° bundle to gain wide adoption, the product family must work seamlessly together, the infrastructure to service and maintain those products must exist, and the products must hold their value over time. Apple is the only company that can bring all three of those together.